I haven’t mentioned it in a while, was trying to give it a rest for a bit, but the front page of the WSJ highlighted this basic economic concept: prices are driven by the market.

The Toyota/lean approach has preached this, that prices are set by the market and the only influence you have over your profit is your costs: Profit = Price (set by the market) – Cost

Traditional manufacturers have viewed price as something that they can set, as they are entitled to a certain profit over and above their costs, the “cost plus” model, where Price = Cost + Profit (entitled).

Parker Hannifin, a company that has done a lot of work with lean, has woken up to this reality, through their CEO:

In early 2001, shortly after Donald Washkewicz took over as chief executive of Parker Hannifin Corp., he came to an unnerving conclusion. The big industrial-parts maker’s pricing scheme was crazy.

For as long as anyone at the 89-year-old company could recall, Parker used the same simple formula to determine prices of its 800,000 parts — from heat-resistant seals for jet engines to steel valves that hoist buckets on cherry pickers. Company managers would calculate how much it cost to make and deliver each product and add a flat percentage on top, usually aiming for about 35%. Many managers liked the method because it was straightforward and gave them broad authority to negotiate deals.

Their pricing policies were shooting themselves in the foot when they actually made improvements:

…if the company found a way to make a product less expensively, it ultimately cut the product’s price as well.

Why? If you can produce something cheaper and the market is still willing to pay the same price…. take the extra profit! Keep it and invest it in the future development and strength of your company. Likewise, if your costs go up (through material costs or labor costs), you have find other ways (such as through lean methods) to get costs down to maintain the same profit. You’re never entitled to price increases because your costs go up. Customers might put up with it in the short term, but they’ll find other options eventually.

The CEO realized this same thing, who knows if the epiphany was divine intervention or if it was through some lean reading:

While touring the company’s 225 facilities in 2001, Mr. Washkewicz had an epiphany: Parker had to stop thinking like a widget maker and start thinking like a retailer, determining prices by what a customer is willing to pay rather than what a product costs to make. Such “strategic” pricing schemes are used by many different industries. Airlines know they can get away charging more for a seat to Florida in January than in August. Sports teams raise ticket prices if they’re playing a well-known opponent. Why shouldn’t Parker do the same, Mr. Washkewicz reasoned.

This basic recognition of supply and demand (something any MBA should know) has really helped Parker:

Today, the company says its new pricing approach boosted operating income by $200 million since 2002. That helped Parker’s net income soar to $673 million last year from $130 million in 2002. Now, the company’s return on invested capital has risen from 7% in 2002 to 21% in 2006, putting it on the verge of moving into the top 25% of Mr. Washkewicz’s list comparing Parker with “peer” industrial companies.

From the end of 2001 to present, Parker’s shares have risen nearly 88% to about $86, compared to a 25% gain in the S&P 500.

The article talks about other companies, including Intel, who use “strategic pricing,” but also points out:

…much of industrial America — 60% of U.S. manufacturers, according to Thomas Nagle, a pricing consultant at the Monitor Group — still relies on oldfangled, “cost-plus” types of pricing methods such as the one Parker used.

The article also points out complicated this change was and how much it was resisted by the internal inertia of the company and its leadership.

There was so much pushback the CEO eventually assembled a list of the 50 most commonly given reasons why the new pricing scheme would fail. If a manager came up with an argument not already on the list, then Mr. Washkewicz agreed to hear it ouht. Otherwise, he told them, get on board.

The article and CEO also blame computers:

To his surprise, Mr. Washkewicz discovered that computer programs for calculating prices, adopted in the 1990s, were part of the problem. “It became a cookbook approach,” he says. Managers typed in myriad costs, and the computer spit out a recommended base price which was used as the starting point in negotiations.

How did customers react to the price increases? Not surprisingly, an auto parts supplier put the parts up for open bid… and couldn’t find someone else to produce the part at that price. Parker only lost 3 out of 50 items that went out for open bid. At least in the short term… only time will tell if they have the right pricing for the long term.

3 Comments on "Parker Hannifin and Market Driven Pricing"

This has been stated a few times, that you can only work on cost because the market sets the price, but it’s not that simple and Toyota does not think that way either. It may be true that the market sets the price with EVERYTHING else being equal, but it’s not equal. The market pays what it pays because of the value provided, whether that value is real (product / service) or perceived (past experience / marketing / brand). This is one reason that Toyota actually gets to charge more for the basically same vehicle, because of that real or perceived value (use the Toyota Matrix / Pontiac Rave as an example). Any company that focuses on cost only will end up in the long run in the gutter, because they forgot to focus on providing more value to the customer. Provide value first, then reduce cost with what’s left.

Also, the “here’s our cost, add 35%” approach usually fails to properly account for cost of capital. If one product line has much more work-in-process inventory than another (because of more fluctuations in order volume, for example) I’m betting that that reality never made it into the “cost” figures.